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Chapter 6: Perfectly Competitive Supply • Derive a supply curve – Opportunity cost The principle of increasing opportunity cost – Seller’s reservation price – Cost-Benefit principle Marginal benefit vs. marginal cost 1 Individual’s Supply Curve • An example – Opportunity cost of Harry's time • Wash dishes for $6 per hour is his baseline • Recycling aluminum cans is the alternative – Harry earns 2¢ per can – How much labor should Harry supply to each activity? • Harry should work at recycling as long as he is earning at least $6 per hour 2 Harry’s Supply Curve Recycling Services Hours per Day Total Number of Containers Found 0 0 1 600 2 1,000 3 1,300 4 1,500 5 1,600 Additional Number of Cans Found 600 400 300 200 100 3 Harry’s Supply Curve Recycling Services Hours per Day Additional Number of Cans Found Revenue from Additional Cans 1 600 $12.00 2 400 $8.00 3 300 $6.00 4 200 $4.00 5 100 $2.00 Harry's rule is to collect cans if the return in an hour is the same as washing dishes; The opportunity cost of collecting cans in an hour is the revenue given up from washing dishes - $6; Therefore, Harry should spend 3 hours in recycling cans. 4 Harry’s Supply Curve Reservation Price Per Can • What is the lowest deposit per can that would get Harry to recycle for an hour? • What price makes his wage at recycling equal to his opportunity cost? 1st hour price is 1¢ 2nd hour is 1.5¢ 3rd hour is 2¢ 4th hour is 3¢ 5th hour is 6¢ Hours per Day Additional Number of Cans Found 1 600 2 400 3 300 4 200 5 100 5 Reservation Price (¢) Number of Cans (00s) 1 1.5 2 3 6 6 10 13 15 16 Deposit (cents/can) Harry’s Supply Curve 6 3 2 1 6 10 13 16 Recycled cans (100s of cans/day) 6 Individual and Market Supply Curves Harry’s Supply Curve Barry’s Supply Curve Market Supply Curve 6 6 6 3 3 3 2 2 2 1 1 1 13 16 15 Recycled cans (00s of cans/day) 6 16 15 Recycled cans (00s of cans/day) 6 13 0 12 26 Recycled cans (00s of cans/day) 32 30 7 Profit Maximization • Economists assume firms seek to maximize profits – Corresponds to buyers' maximizing utility • Profit is total revenue minus total cost – Both explicit and implicit costs are included in total cost 8 Perfectly Competitive Firm 9 Perfectly Competitive Firm's Demand • Market supply and market demand set the price – Buyers and sellers takes price (P) as given • Perfectly competitive firm can sell all it wants to sell at the market price – Since the supplier is small, its output decision will not change market price – Each firm must decide how much to supply (Q) 10 Perfectly Competitive Firm's Demand 11 Profit Maximization – An Example • In the example, the model has a single product and two inputs, labor and capital – Capital is fixed, labor is variable • Determine the profit maximizing level of output for a perfectly competitive bottle manufacturer • Capacity of the bottle-making machine is fixed 12 Law of Diminishing Return The Law of Diminishing Returns With all inputs except one fixed, additional units of the variable input yield ever smaller amounts of additional output 13 Law of Diminishing Return • At low levels of production, the law of diminishing returns may not hold – Similar to the increase in a buyer's marginal utility from a second unit • As with marginal utility, marginal product eventually diminishes – Lower marginal products are often caused by congestion • Workers per machine • Information flows 14 Cost Concepts • A fixed factor of production is an input whose quantity cannot be changed in the short run – Fixed cost (FC) is the sum of all payments for fixed inputs • A variable factor of production is an input whose quantity can be changed in the short run – Variable cost (VC) is the sum of all payments for variable inputs • Total cost (TC) is the sum of all payments for inputs • Marginal cost (MC) is the change in total cost divided by the change in output 15 Profit Maximization - Data Workers Bottles per Day Fixed Costs ($/day) Variable Cost ($/day) Total Cost ($/day) 0 0 $40 $0 $40 1 80 40 12 52 2 200 40 24 64 3 260 40 36 76 4 300 40 48 88 5 330 40 60 100 6 350 40 72 112 7 362 40 84 124 Marginal Cost ($/bottle) $0.15 0.10 0.20 0.30 0.40 0.60 1.00 16 Profit Maximization Profit = Total revenue – Total cost • Since Total cost = Fixed cost + Variable cost Profit = Total revenue – Variable cost – Fixed cost • The firm must know about both revenues and costs in order to maximize profits – Increase output if marginal benefit is at least as great as marginal cost – Decrease output if marginal benefit is less than marginal cost 17 Profit Maximization • Firms maximize their profit when marginal benefit equals marginal cost; • In a perfectly competitive market, marginal benefit is simply the market price, which is a constant; • Fixed costs do not affect the marginal cost, since the change in fixed costs is zero. 18 ATC, AVC, and MC • Average values are the total divided by quantity – Average variable cost (AVC) is AVC = VC / Q – Average total cost (ATC) is ATC = TC / Q • Marginal cost (MC) – MC = ΔTC/ΔQ 19 Cost Structure Worker Bottles s per per day day Variabl e Cost ($/day) AVC ($ per unit) Total Cost ATC ($ per unit) 40 Margin al Cost ($/unit) 0 0 0 1 80 12 0.15 52 0.65 0.10 2 200 24 0.12 64 0.32 0.20 3 260 36 0.135 76 0.292 0.15 20 Cost Structure – A graph 21 Profit Maximization – A graph • Market price is $0.20 per bottle – Produce where the marginal benefit of selling a bottle (price) equals the marginal cost • 260 bottles per day 22 Profit Maximization – A graph 23 Production Loss – A graph 24 Shut Down Decision • Firms can make losses in the short run – Some firms continue to operate – Some firms shut down If the firm shuts down in the short run, it loses all of its fixed costs; The firm should shut down if revenue is less than variable cost: P x Q < VC for all levels of Q; The firm should continue its business if revenue is at least larger than variable cost. 25 Shut Down – A graph MC ATC AVC Price Output (bottles/day) 26 "Law" of Supply • Short-run marginal cost curves have a positive slope – Higher prices generally increase quantity supplied • In the long run, all inputs are variable – Long-run supply curves can be flat, upward sloping, or downward sloping • The perfectly competitive firm's supply curve is its marginal cost curve – At every quantity on the market supply curve, price is equal to the seller's marginal cost of production – Applies in both the short run and the long run 27 Increases in Supply 28 Producer Surplus • Producer surplus is the difference between the market price and the seller's reservation price • Reservation price is on the supply curve • Producer surplus is the area above the supply curve and below the market price 29